Use MLPs to beat a capital gains tax increase

Ivan Martchev is an investment specialist with institutional money manager
Navellier and Associates.
Previously, Ivan served as editorial director at
InvestorPlace Media. Ivan was
editor of Louis Rukeyser's Mutual Funds and associate editor of Personal
Finance. Ivan is also co-author of
The
Silk Road to Riches (Financial Times Press).

When investors evaluate fixed-income assets, the rule of thumb is "the higher the yield, the higher the risk."

But with higher-yielding strategies like dividend-paying stocks, real estate investment trusts and master-limited partnerships, it gets more complicated: "The less secure the yield — be it as dividends or MLP distributions — the higher the risk."

Naturally, the question arises: How does one evaluate such yields — particularly with a likely dividend tax hike just a few weeks away?

Many yield hunters have more or less forgotten the basic concepts of capital structure. Shareholders own and bondholders lend, or that dividends are at discretion of the board, while bond interest is an obligation. Many investors, prodded by the Federal Reserve out of the bond market thanks to numerous rounds of quantitative easing, have been hiding in dividend-paying stocks, MLPs and REITs only to get caught a bit flat-footed by the impending fiscal cliff.

Their post-election reaction? They have been selling. Why? Because the tax rates on dividends and capital gains are set to head higher.

While it is impossible to predict what type of compromise, if any, the White House and Congress will have in the next six weeks, it is possible to figure out a winner on this investment tax-hike situation: MLPs.

The Theory

MLPs, unlike corporations, have no taxes on distributions to shareholders, so there is no real fiscal-cliff tax effect (other than the one brought on by panicky sellers who have not done their homework). While MLPs trade like stocks on an exchange, their shares are referred to as units and their shareholders as limited partners. The "dividends" in this case are called "distributions," and they are paid every quarter just like regular dividends.

Dividends currently are taxed at a 15% rate, but MLP distributions are taxed at the individual's marginal tax rate, as there is no corporate double taxation. Limited partners holding MLPs in taxable accounts can also use depreciation charges from the MLP to decrease their individual tax liability.

Most MLPs are concentrated in the energy sector and typically are fee businesses that have to do with the transportation and processing of commodities, and they typically have to distribute all of their available cash to unitholders.

MLPs also have seen a windfall in recent years from shale oil and gas exploration as rising domestic volumes have meant more income for existing pipelines, as well as processing and storage facilities. Domestic production is expected to continue to climb, with U.S. energy independence possible by 2020 given current trends — which is why most MLPs transporting energy are in a long-term bull market.

The Practice

Still, despite no fiscal-cliff tax effect, MLPs did sell off after President Obama won the election. But why?

I have been around financial markets for 15 years, and if I have learned anything, it's that the efficient-market hypothesis is pure baloney. There is no such thing as a completely rational market reaction; on rare occasions, the market can swing all the way to pure irrationality.

My favorite example in the sector is an MLP called Teekay LNG PartnersTGP, -2.11%
— an MLP operates primarily liquefied natural gas (LNG), liquefied petroleum gas (LPG) and some oil tankers leased at long-term contracts with no exposure to the spot market.

In 2008, when the spot-pricing shipping indexes collapsed, investors sold TGP shares along with those of the spot shippers, even though TPG was never in danger of missing a unit-distribution payment. The same is true today for Teekay LNG Partners, as management targets to lock in cash flows with 10- to 25-year contracts, with remaining contracts on the books of 14 years (for LNG), 13 years (for LPG) and 8 years (for oil tankers). There is a little rollover risk far into the future, but long-term and spot pricing has always been very different, and TPG certainly has the expertise to manage it.

Another interesting MLP is Oneok PartnersUS:OKS
a leader in the processing, storage and transportation of natural gas in the U.S. Oneok Partners also owns one of the nation's premier natural gas liquids (NGL) systems. The units have an indicated yield of 4.7%, which has dropped off quite a bit from the five-year average of 6.5%. This is a good problem to have, as it has not been due to falling distributions — they have risen steadily in that period.

One mistake investors make is to casually look at payout ratios just like they do with dividend stocks. Since there are no earnings to be taxed, there is no amount of after-tax earnings to pay out. Investors should look at distribution coverage ratios, which are typically high as the partnership is mandated by law to distribute the majority of its so-called "margin."

Oneok Partners has had steady margin growth, from $896 million in 2007 to an estimated $1.6 billion for 2012. During this time, the ratio of fee-based (non-fluctuating) margin has ranged from 52% to 68%. The goal is to make that as high as possible, though the variability of the rest of cash-flow generation is much smaller due to the typical multi-year hedging strategies that are popular in the industry. Natural gas prices have been in quite a long-term decline, save for a 2012 rebound, but natural gas volumes have been rising over the long-term, which is what is more important here.

Those looking to play the rise in domestic crude oil volumes should investigate Plains All American PipelinePAA, -4.14%
Since 1993, Plains has been a major player at the hub of storage of crude oil in Cushing, Okla. The Plains terminal has been expanded on 11 occasions to more than nine times its original size to capitalize on the growth in the North American crude oil distribution system.

The way new drilling methods have caused domestic oil and natural gas volumes to rise in the past five years, it looks like there will be more expansions to come no matter how much taxes go up on Jan. 1.

While MLPs have attractive features, there are potential risks an investor should consider prior to investment in such securities: (1) Commodity Price Risk - MLPs can be subject to commodity price risk when there is a decline in exploration, transport, and processing of energy products related to volatile energy prices. (2) Correlation Risk - While MLPs have historically low correlation to other asset classes, there has been a measurable increase since the financial crisis of 2008. This pattern has been present in other times of severe equity market stress. (3) Limited Liquidity - While liquidity has improved with investment vehicles like mutual and closed end funds, the ability to buy and sell is still somewhat constrained when compared to traditional investments such as equities. (4) Tax liability for tax exempt investors. Other potential issues include changes in the regulatory climate for energy-related activities, tax law changes, supply disruptions, environmental accidents, and terrorism. Interest rate risk may increase the potential cost of financing projects and affect the demand for MLP investments; this translates into lower valuations.

Ivan Martchev is a research consultant with institutional money manager Navellier & Associates. The opinions expressed are his own. Navellier & Associates holds positions in Oneok Partners and Plains All American Pipeline for its clients. This is neither a recommendation to buy nor sell the stocks mentioned in this article. Investors should consult their financial adviser prior to making any decision to buy or sell the aforementioned securities.

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